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I origninally posted this in April 2013. Now the Nasdaq Golden Dragon China index is up 50%.

Chinese Take-Away Becoming Tempting Again

Markets always overreact, and currently “Chinaco”- Chinese companies listed in North America – are feeling the brunt of a number of high profile failures. But if a trend cannot continue forever, it will end, and the negative sentiment about Chinaco will turn (if it hasn’t already.) Investors should pay attention. Remember the dot-com crash? How nobody would ever buy shares again when value was determined by eyeballs? “Bricks and mortar” was the way to go, for sure. And what are Facebook/Linkedin/Groupon trading at? Do they have impressive assets? No. The internet economy simply got too big to ignore, and investors returned.

I’m biased. I’ve worked with China-sector companies for a decade, raising money, working on boards, and doing due diligence. I’ve seen good companies and horror shows. While painful, the recent pull back in the markets has improved the investment appeal in Chinaco, just as the investment appeal for the internet stocks returned following their crash. Plus, selfishly I’d like to get my phone calls returned. So, thank you, Carson Brock, et. al, for popping the balloons. Now its time to get back to the party.

1. Quality Is Improving and a New Sheriff is in Town

Prior to 2010, with huge investor demand for Chinaco, due diligence suffered. Investment banks, brokerages, auditors, and even stock exchanges competed to bring issues to the market to satisfy the demand and basics were overlooked. Times are changing. Chinese companies are now scrutinized to a level that is far higher than a ‘domestic’ company. Auditors are spooked.

What’s new is that scrutiny also now applies in the PRC. Why is this so important?? Shortly before the Beijing Olympics, it emerged that a Chinese company had been selling milk laced with melamine. Tragic and very embarrassing, as it put the whole country’s food safety into question. The fiasco led to sweeping changes in the milk supply chain and the ultimate punishment doled out to two company executives. Lesson: it isn’t a good career move to embarrass the government.

In Beijing last year, I spoke with a high-ranking official who made it clear that the government was embarrassed by the reputation of Chinaco. They don’t need to raise capital – with 78 million retail investors and national savings of $US4 trillion they could easily internally raise non-governmental equity. But the Chinese are pragmatic, and know that in order for their companies (either SOE or privately held) to acquire assets overseas, they need to provide western-level transparency and governance.

China Securities Regulatory Commission Chairman Guo Shuqing, highlighted the problems at the Asian Financial Forum in 2013. “There is a lack of market integrity and legal awareness among some market players. Some listed companies make frauds in disclosure and financial statements. Insider trading and market manipulation happen from time to time.”

Domestically, it is not simple posturing. In 2012 the CSRC suspended domestic IPO markets and imposed more stringent, verifiable disclosure requirements on over 800 issues in “IPO Alley.” They initiated investigation of 143 cases, 24% higher than the year before. Uncommonly for China, the rulings are publicized. Every indication is that the standards will apply on overseas listings. Effective January 1, 2013, the CSRC lowered the size required for Chinese companies to list overseas, but also required the company to get approval from the CSRC to do so.

The state-controlled media has lost its reluctance in publicizing Chinese stock fraud abroad. China Central TV news has investigated the recent Longwei Petroleum scandal. “What goes on the road, stays on the road” no longer applies to philandering overseas listed Chinesecompanies.

Demand Will Increase

Investors won’t be able to ignore China sector stocks for too much longer. The numbers in all categories don’t need to be rehashed. Simply, China’s economy is on route to being the world’s largest.

Today’s shunning of “Chinese junk” – be it a product or a security – ignores reality. Iphones are made in China and China supplies 20% of Apple’s revenue -people don’t have a problem with either the product or the shares. Already, most of the revenue growth amongst the S&P 500 is from overseas (the largest part being China), and so investors are already participating in Chinese growth. Inevitably, demand for China “pure plays” will follow.

During earlier waves of enthusiasm for Chinaco, institutional investors piled into China, and felt the pain of the correction, but now Hedge Fund capital is increasingly returning. Institutional Investor reports that currently only 5% of institutional assets are in emerging markets that have 55% of world population. In the last quarter of 2012, according to Hedge Fund researcher HFR, capital invested in emerging markets rose by $11.2 billion to a record $139 billion. As investors get more comfortable with economic infrastructures, investment will increase as it becomes more difficult to generate sustainable returns in developed markets.

The Economist has gone so far to suggest that Alibaba, a Chinese internet company,could become the world’s most valuable company when it completes its IPO. Investors shouldn’t entirely don rose-coloured glasses; the Economist cautions that Alibaba, although having reasonably standards of transparency and corporate governance, stands out simply because China still has low standards for corporate governance generally. But it is generally improving.

Supply Is Shrinking

This infuriates China-Conspiracy-Theorists, since they are convinced that the master plan was to fleece investors and then buy the companies back cheap. Ultimately, though, going private must always be an option when being listed becomes too much of a hassle and/or valuations aren’t there.

Whilst in the lead up to the crash, regulators/auditors, etc, were too loose with the new listings flooding the market, the pendulum has swung. Regulatory overview of Chinaco has become overwhelming. Auditors have required audit evidence far higher than that required by other companies – in some cases to a level that could never be achieved. Audit fees have doubled and trebled. Its difficult to get directors willing to come on board.

Those that have survived the regulatory mauling are often trading at very low PE multiples, or even below net cash value. More than a dozen companies have announced their intention to privatize. The China Development Bank is providing more than $1 Billion in lending to help companies leave the US stock markets. At the same time, fewer listings are being sought.

Perhaps the solution for Chinaco is to change names, make them less “Chinese”. The best strategy for companies after the dotcom crash was to change names and avoid the post boom-and bust hangover. In a scholarly peer reviewed paper, Cooper et al (Purdue University) determined that in 1999, listed companies adopting internet related “dot com” names had a sustained 32% return. After the crash, the authors revisited their study and found that removing internet related dotcom names had a sustained 64% return!!

Some investors are getting on board, the Bloomberg Chinese Reverse Mergers Index is up 25% from the low point in the summer of 2012. But valuations remain far lower than a few years ago. A portfolio of 12 Chinacos on the TSX purchased at the beginning of 2011 shows a cumulative decline of 70%.

Some companies that I like include: Shanda Games (GAME), ChinaCache International (CCIH) and Perfect World (PWRD), because of the potential for going private; and SilverCorp (SVM) which has extraordinarily attacked and looks due for a rebound. ChinaEducation Network (CHNUF) and CIBT Education Group (MBA) are interesting because their potential in the Chinese education market has been largely ignored.

I’m not advocating that investors throw caution out of the window. There will undoubtably be other scandals. Due diligence is key. My point is that while the Chinese do have a proverb “浑水摸鱼” (muddy waters make it easy to catch fish), they also have the proverb 風向轉變時,有人築牆,有人造風車(when the wind of change blows, some build walls, while others build windmills.) Seems to me, its time to build windmills, and take another look at Chinaco.

Based in Vancouver, Stuart Wooldridge works with Chinese companies and institutional investors.